3 The Price System

When Is the economy self-perpetuating or does economic growth necessarily end? Consumption and Investment is the choice between satisfying wants today or tomorrow. In market economies, the interest rate determines the cost of this choice, allocating resources efficiently across time

3.1 The Free Market System (Capitalism) The market allocation mechanism uses ‘market-determined’ prices that ‘signal’ consumers & producers as to what is more & less desirable (valuable) output & allocate scarce resources accordingly (the Classical School). Interactions between consumers & producers & the choices they make determine how much is produced & at what price. To make ‘free’ (from coercion) choices, property rights must exist. To maximize profits, producers will seek to use lowest-cost methods of producing a good; competition prevents them from charging above-market prices.

3.1 The Free Market System (Capitalism) A market distributes goods to the highest bidder, ie those who are willing & able to pay the most for a good. ‘Laissez faire’ is the doctrine of ‘leave the market alone,’ ie, no intervention/interference by government in the workings of the market.

3.2 Government Intervention & Command Economies Karl Marx (Germany) criticized free markets for concentrating wealth & power in the hands of the few at the expense of the many. Marx argued that markets permit capitalists (those who own the machinery & factories) to enrich themselves while the proletariat (the workers) toil long hours for subsistence wages; moreover, Marx argued that capitalism will collapse as firms compete for foreign markets &, thus, countries will go to war & worker would unite across the globe & overthrow their governments. Accordingly, Marx argued that the government not only had to intervene but had to own all the means (factors) of production.

3.2 Government Intervention & Command Economies John Maynard Keynes (UK) believed that markets work but that market-clearing processes were too slow at the macro-economy level ‘In the long-run we are dead!’ Keynes argued that government should play an active role in managing the demand-side of the economy during business cycles (macro-wide shortages & surpluses) by putting more (or less) money in the economy to stimulate (reduce) output. Today nearly all economies (to a greater or lesser extent) are ‘mixed’ in that they use a combination of market signals & government directives to determine economic outcomes.

3.3 Continuing Debate The core of most debates is some variation of the WHAT, HOW, FOR WHOM, WHEN questions. Conservatives favor Adam Smith’s laissez-faire approach. Liberals tend to think government interventions are likely to improve economic outcomes. Neo-classical economists today argue that Keynesian-inspired demand-side management of the economy can make things worse by ‘overshooting’ the target ‘The long-run is here & Keynes is dead!’

3.3 Continuing Debate Neo-Classical economists argue that the economy is too complex & requires too much ‘real-time’ information to determine with precision how far the economy deviates from (long-run) macro equilibrium (the Policy Target) &, thus, the degree of government activism required. Under the theory of Rational Expectations, Neo-classical economists contend that if government macro policies are fully anticipated, then such policies become completely ineffective for changing macroeconomic outcomes.

3.4 Market Failure (Anomaly) Equity: Equal distribution of wealth (scarce resources) Public goods Externalities Market power & Natural monopoly Macro instability

3.5 Theory of Demand Demand is an expression of a consumer’s buying intentions. A demand curve illustrates the quantities of a good a consumer is willing & able to buy @ alternative prices (ceteris paribus). According to the Law of Demand the quantity of a good demanded increases (decreases) as its price falls (rises), ceteris paribus, indicating a negative relationship (slope). A market demand curve illustrates the quantities of a good all participating consumers are willing & able to buy @ alternative prices, ceteris paribus. Market demand is a ‘merging’ of individual demand curves.

Demand curve D1 P Q1

Determinants of Demand (Independent variables) Tastes Income Price of other (related) goods Expectations of the future Number of buyers Changes in the determinants (causes) of demand result in a shift of the demand curve to the right or left.

Shifts in Demand A demand curve is valid so long as the underlying determinants remain constant; determinants of demand are always taking on new values. A shift in demand is a change in quantity-demanded @ every price. Shifts of the demand curve, referred to as changes in demand, occur when the determinants of demand change.

Demand curve shifts D1 D2 D3 P Q1 Q3 Q2

3.6 Theory of Supply Supply is an expression of a suppliers’ selling intentions. A supply curve illustrates the quantities of a good a producer is willing & able to sell @ alternative prices, ceteris paribus. According to the Law of Supply, the quantity of a good supplied increases (decreases) as its price rises (falls), ceteris paribus; indicating a positive relationship (slope). A market supply curve illustrates the quantities of a good all participating suppliers are willing & able to sell @ alternative prices, ceteris paribus. Market supply is a ‘merging’ of individual supply curves.

Supply curve S1 P Q1

Determinants of Supply (Independent variables) Factor costs Technology Profitability of alternative pursuits (ie prices of other producible goods) Expectations of the future The number of sellers Changes in the determinants (causes) of supply result in a shift of the supply curve to the right or left.

Shifts in Supply A supply curve is valid as long as the underlying determinants remain constant; like demand, determinants of supply are always taking on new values. A shift in supply is a change in quantity supplied @ every price. The purpose of drawing supply & demand curves is to see how markets answer the basic questions of WHAT, HOW, & FOR WHOM. Only one price & quantity is compatible with the existing intentions of both buyers & sellers @ a point in time.

Supply curve shifts S3 S2 S1 P Q3 Q2 Q1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3.7 Disequilibrium: Surplus Market surplus is the amount where quantity-supplied exceeds quantity-demanded @ a given price (excess supply). A surplus indicates the good is ‘over-valued’ by the market. A market surplus is created when sellers’ asking prices are ‘too high’ (ie, above the equilibrium price).

Market Dis-equilibrium: Surplus P Q S D Surplus

Market Dis-equilibrium (cont) P Q S D Surplus

3.7 Disequilibrium: Shortage Market shortage is the amount where quantity-demanded exceeds quantity-supplied @ a given price (excess demand). A shortage indicates the good is ‘under-valued’ by the market. A market shortage is created when sellers’ asking prices are ‘too low’ (ie, below the equilibrium price).

Market Dis-equilibrium: Shortage P Q S D Shortage

Market Dis-equilibrium (cont) P Q S D Shortage

3.8 Equilibrium The equilibrium or market-clearing price is the unique price where quantity-demanded equals quantity-supplied (where excess supply/demand is zero). Adam Smith described the adjustment process of the price system as ‘an invisible hand’ guiding free market economies to optimal resource usage.

Market Equilibrium P Q S D

3.9 Changes in Supply and Demand Conditions (Equilibrium): Demand When demand or supply conditions change (ie, curves shift) the result is a new equilibrium price & quantity outcome. When demand increases the new eq. price & quantity is higher. When demand decreases the new eq. price & quantity is lower.

Demand conditions change (curve shifts) P Q S1 D2 D1 P2 P1 Q1 Q2

3.9 Changes in Supply and Demand Conditions (Equilibrium): Supply When supply increases the new eq. price is lower & quantity is higher. When supply decreases the new eq. price is higher & quantity is lower.

Supply conditions change (curve shifts) Q S1 S2 D1 P1 Q1 P2 Q2

Price ceilings Price ceilings are market prices deliberately set below equilibrium by law (eg rent controls, usury laws). Price ceilings decrease quantity-supplied/increase quantity-demanded. Price ceilings create a market shortage & are thus inefficient.

Price floors Price floors are market prices deliberately set above equilibrium by law (eg minimum wage). Price floors increase quantity-supplied/decrease quantity-demanded. Price floors create a market surplus & are thus inefficient.

6 Conclusions In free markets prices act as ‘signals’ to indicate what goods are relatively more or less valuable. Market-determined prices allocate goods and services efficiently by eliminating wasteful shortages and surpluses. The equilibrium market price is not determined by any single consumer or supplier but by their collective decisions, each acting in his or her own best interest. The allocation process of free markets performs automatically without the need (or cost) of any centrally-managed direction.